Warren Buffett made a friendly bet four years ago that funds that invest in hedge funds for their clients couldn’t beat the stock market over a decade. So far he’s winning.

The wager that began on Jan. 1, 2008, pits the Omaha, Nebraska, billionaire against Protégé Partners LLC, a New York fund of hedge funds co-founded by Ted Seides and Jeffrey Tarrant. Protégé built an index of five funds that invest in hedge funds to compete against a Vanguard mutual fund that tracks the Standard & Poor’s 500 Index. The winner’s charity of choice gets $1 million when the bet ends on Dec. 31, 2017.

The Vanguard fund’s low-cost Admiral shares returned 2.2 percent, with dividends reinvested, from the start of the bet through Feb. 29, as stocks rebounded from a 12-year low in March 2009. The hedge funds fell about 4.5 percent, based on Protégé’s index returns for the first three years and results since then for the Dow Jones Credit Suisse Hedge Fund Index, which has roughly tracked the group of unidentified funds when adjustments are made for extra fees.

“Hedge funds of funds have underperformed because of high fees and mediocre manager selection,” said Brad Alford, head of Alpha Capital Management LLC in Atlanta, which runs a mutual fund of funds designed to replicate the performance of hedge funds with lower fees and the flexibility for clients to pull money out daily. Since 2009, his Alpha Defensive Growth (ACDEX)strategy has posted an annual average return of 8.2 percent, almost twice the return of hedge fund of funds.

Neither Buffett nor Scott Tagliarino, a spokesman for Protégé, would comment on the bet’s progress.

Assets Decline

Funds of funds have seen clients flee in the past five years. Some of the largest U.S. public pension funds, including those in Massachusetts, South Carolina and New York, started investing directly in hedge funds instead of going through an intermediary in an effort to reduce fees and boost returns.

The amount of money they control has fallen by about one- fifth to $630 billion as of the end of 2011, compared with a year-end peak of $780 billion in 2007, according to Hedge Fund Research. Funds of funds were the industry’s biggest investors in 2007, holding about 43 percent of assets.

Buffett’s argument, like the large pension funds, is that funds of hedge funds cost too much, according to a statement he posted on longbets.org, a website backed by the nonprofit Long Now Foundation that fosters “long-term thinking.” In addition to the 2 percent management fee and 20 percent performance fee that hedge funds typically charge, the funds of funds add another layer of fees, on average 1.25 percent of assets and 7.5 percent of any gains, according to data compiled by Bloomberg.

Wheat From Chaff

Protégé said in its statement that because hedge funds can make bets on rising as well as falling prices of stocks, bonds, currencies and commodities, they are able to beat the S&P 500 even after fees, and that sophisticated investors such as fund- of-fund managers “with the ability to sort the wheat from the chaff” will earn returns that amply compensate for the extra costs.

The returns of Protégé’s index from 2008 through 2010, reported in Fortune magazine a year ago by long-time Buffett friend and chronicler Carol Loomis, are similar to those of the Dow Jones Credit Suisse Hedge Fund Index, after adjusting for the added fees charged by hedge fund of funds. That index fell 2.5 percent last year, and rose 4 percent in the first two months of 2012.

Protégé took the lead in the first year of the bet as its fund of funds index lost 24 percent and Vanguard’s fund declined by 37 percent. Buffett narrowed the gap in subsequent years. The S&P fund returned 27 percent in 2009, compared with a gain of 16 percent for the hedge funds, according to Fortune. The stock fund rose 15 percent in 2010 as the hedge funds advanced 8.5 percent.

Overtaking Hedge Funds

The 81-year-old Buffett, who is chairman of the holding company Berkshire Hathaway Inc. (BRK/A), ended last year neck and neck with the Protégé funds as the Vanguard fund climbed by 2.1 percent and the Protégé hedge funds lost an estimated 3.75 percent.

The first two months of this year pushed the Vanguard fund ahead as stocks returned 9 percent, more than twice the gains of hedge funds.

Buffett, who told Loomis in 2008 he placed his chances of winning at 60 percent, had originally suggested a bet against single-manager hedge funds. Had he found a taker, he would be trailing by about 6 percentage points based on the Dow Jones Credit Suisse index.

If Buffett had bet returns of his own holding company against the performance of hedge funds, he’d be even farther behind. Berkshire Hathaway shares have slumped almost 17 percent since the end of 2007.

To contact the reporter on this story: Katherine Burton in New York at kburton@bloomberg.net

To contact the editor responsible for this story: Christian Baumgaertel at cbaumgaertel@bloomberg.net